This page specifically covers how home mortgage refinancing can land you in hot water or be a welcome change providing a financial boost. If you just want an overview of how home mortgage refinancing works before weighing the pros and cons, get the facts by reviewing Mortgage Refinancing Basics. As a refresher, when you refinance your mortgage, you get a new loan that pays off your existing debt. Doing so can result in lower monthly payments unless you take out a substantial amount in cash. In general, you should avoid refinancing your mortgage if you’ll waste money and increase risk. It’s easy to fall into the traps below, so make sure you steer clear of these common mistakes.
Extending a Loan’s Term
When you refinance, you typically extend the amount of time you’ll repay your loan. For example, if you get a new 30-year loan to replace your existing 30-year loan, payments are calculated to last for the next 30 years. If your current loan only has 10 or 20 years left to go, refinancing is likely to result in higher lifetime interest costs. Here’s why: When you get a new loan with a long term, most of your payments go toward interest charges in the early years. But with an existing loan, you might have already moved past those years, and your payments could be making a meaningful dent in your loan balance. If you refinance, you have to start from scratch. To avoid losing substantial ground, you could choose a shorter-term loan, such as a 15-year mortgage. To see this in action, plug your numbers into our mortgage calculator to see how much interest you’ll pay over the life of the new loan. While you’re at it, learn how amortization works if you’re curious about the process of paying down loan balances.
Closing Costs
Refinancing a home loan costs money. You typically pay fees to your new lender to compensate them for offering the loan. You may pay a variety of charges for legal documents and filings, credit checks, appraisals, and so forth. Even if a loan is advertised as a “no closing cost” loan, you still pay to refinance. In many cases, that happens through a higher interest rate than you would otherwise pay. To better understand no closing cost refinance loans, research the basics of such loans to avoid common pitfalls.
Debt Consolidation
You can use home equity to consolidate debts. To do so, you might refinance your existing loan with an even larger loan. Also known as cash-out refinancing, this approach provides additional cash that you can use to pay down credit cards, auto loans, and other debts. Debt consolidation may seem appealing because you reduce interest rates on your debt by converting consumer debts into lower-interest-rate home equity debts. But that move can backfire if all you do is free up capacity on your credit cards and rack up more consumer debt. Moving debt around is not the same as paying it off. It can also backfire if you are unable to pay the larger loan balance and risk losing your home. If you’re having trouble paying consumer debts, think twice before putting your home on the line. Consider enrolling in a debt consolidation program before taking such a drastic step.
Recourse Debt
In some states, home purchase loans have special protection from creditors: In the event of foreclosure, lenders might not be allowed to sue you if they lose money on your loan and subsequent home sale. Those legal actions, known as deficiency judgments, can haunt you even after you leave your home. But those rules apply to your original purchase loan, and refinancing your mortgage changes the nature of your loan: It’s no longer the original loan you used to purchase your home. As a result, you may lose some protection.
